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It’s likely appropriate soon
That rates will be raised, prob’ly June
Or so said the Fed
When Minutes were read
By traders Wednesday afternoon

But also, that self-same report
Explained that the Fed would not thwart
A rise in inflation
Unless the formation
Of bubbles caused them to abort

Yesterday’s price action was a study in contrast. The morning was dominated by the growing fear of contagion as the ongoing rout in the Turkish lira led to a decidedly risk-off tone in markets. Equity markets fell around the world and the dollar, yen and Treasuries all rallied. This was even in the wake of the Turkish central bank finally responding to the lira’s sharp decline and raising a key interest rate 300bps. While that had a temporarily positive impact on TRY, it was not nearly enough to turn broader market sentiment around.

But when the FOMC Minutes were released yesterday afternoon, the market gained a new, happier perspective on the world. While the Minutes made clear that the Fed was going to raise rates in June, it remained circumspect on whether there will be one or two more additional rate hikes coming. But what really turned things around was when traders and investors saw the following words, [a period of inflation] “modestly above 2 percent would be consistent with the committee’s symmetric inflation objective and could be helpful in anchoring longer-run inflation expectations.” In other words, the discussion about the symmetry of the 2.0% inflation target was reaffirmed.

The implication is that even as inflation continues to print higher over the coming months, and that seems almost baked into the cake given the arithmetic behind the calculation, the Fed is telling us that they are not going to overreact and raise rates more aggressively than currently forecast. I guess the new debate will be on just what defines ‘modestly.’ Is 2.2% modestly above their target? What about 2.5%? Is there even a number that the FOMC members have in mind? However, the one thing that is clear is that the market has reduced the expected trajectory of Fed rate hikes, and that led to very predictable outcomes. The first was that the US equity markets, which had been under pressure prior to the Minutes, all rebounded and closed higher on the day. The second was the dollar, which has been a huge beneficiary of the evolving theme that the Fed was going to get more aggressive, gave back some recent gains. And finally, Treasury yields fell further as the fear over inflation in the long run was overwhelmed by the idea that the Fed would not be in the business of driving the short end of the yield curve up to inversion.

Which brings us to today’s session. The dollar has continued to cede ground, down broadly, although not universally. For example, the most notable data from the Eurozone was a softer than expected German GfK Consumer Confidence print at 10.7, but the euro is still higher by 0.2%. On the positive side, UK Retail Sales in April were much firmer than expected, rising 1.6% in the month, and helping instill some confidence in the prognosis for the UK economy. It can be no surprise that the pound is the leading gainer today, up 0.4%.

But arguably, the most notable news after the Minutes was the new threat of tariffs of up to 25% on imported automobiles into the US on national security grounds. It should be no surprise that car manufacturers’ stock prices have all suffered, or that the equity markets in both Tokyo and Seoul fell after the news was reported. My sense is that this may also be a tacit way for the administration to signal it wants to see the dollar retreat a bit. Remember, back in February both President Trump and Treasury Secretary Mnuchin discussed how a weaker dollar was beneficial to the US manufacturing sector. While we haven’t heard much on that front lately, I’m confident they are not unhappy that their comments are having this effect. But in the end, barring actual activity by the Treasury on the subject, which I think is an extremely remote probability, the market will continue to focus on the Fed, the ECB, the BOE and their brethren central banks. In other words, FX markets will continue to be driven by central bank activity and expectations thereof.

Putting it all together, the implication is that markets are going to be watching the data even more closely as the central banks are truly becoming data dependent. For the Fed, clearly the PCE data is going to be the primary data point, although CPI will still affect market movement. In the UK and Eurozone, I think the growth story will be the driver, as the ECB has made clear they want to remove QE but need justification to do so, and that justification will come from an end to the recent down trend in economic statistics. Japan is still on the inflation train, so higher prints there will offer the opportunity for the BOJ to back away from some of their QQE. And generally, every G10 central bank will be even more focused than usual on the data results.

The dollar has had an awfully good run for the past six weeks, regaining all of its lost ground from earlier this year and starting to cut into last year’s losses. My take is that the Minutes are going to bring a halt to that run for the time being. I don’t expect the dollar to fall sharply, simply to consolidate its recent gains. However, despite the Fed’s clear willingness to allow inflation to rise above their target, I think that is a limited resource, and one that will be used up before the end of the summer. If pressed, while 2.2% is probably not going to raise any hackles on the FOMC, I think that anything above 2.3% will be seen as courting danger and draw out a completely different tone from the Fed. For now, though, it is a waiting game. Better than expected US data will see the dollar benefit somewhat, and worse than expected data will see it fall. Of course, this all presumes that some emerging market doesn’t go pear-shaped, and cause a broader risk-off meme. In that event, the dollar will benefit just like in the old days!

Today brings the weekly Initial Claims data (exp 220K) and Existing Home Sales (5.60M), neither of which seems likely to drive markets. We continue to hear Fed speakers, as well as other central bank speakers, and until the PCE data gets released next week, I expect that will be the most interesting thing to market participants. Early this morning, BOE Governor Carney and NY Fed President Dudley both spoke at a conference and discussed the replacement of LIBOR, not monetary policy. But we hear from both Bostic and Harker later today, and much more importantly, Chairman Powell tomorrow morning. So there is still plenty that can happen.

According to data today
From Europe and from the UK
Those stories ‘bout growth
Depicted by both
Are now showing signs of decay

Remember when the Eurozone was growing above potential? Yeah, me neither! But in fairness, in 2017, the bloc did have a (relatively) blockbuster year, where GDP in the Eurozone grew 2.4%, which is well above most economists’ estimates of how fast it can grow over time. And it was faster than US growth as well, which of course was one of the reasons that the euro rallied 11% vs. the dollar last year. You might remember the meme that arose from that story, ‘global synchronous growth,’ which was going to be the key behind the ECB exiting QE and starting to normalize monetary policy. That was also the rationale behind the UK preparing to raise rates despite Brexit, and the main argument as to why the dollar was destined to fall much further.

But that is so last year. We are now five months into 2018, a pretty good chunk of the way, and the data we continue to see from both the Eurozone and the UK has basically demonstrated that 2017’s growth meme seems to have ended. Thus far, the euro bulls have relied on the idea that the slowdown in Q1 was a result of extremely cold weather, a flu epidemic and some labor strife. But now we are two-thirds of the way through Q2 and the data is simply continuing to trend lower with no sign of slowing down. (For example, German manufacturing PMI fell to 56.8, its lowest level since February 2017, with all the major subcomponents falling.) The point is that Mario Draghi and his compatriots at the ECB have to be looking at the data and starting to ask themselves just how anxious they are to change their current monetary policy settings. Continuing down the path of reducing accommodation amid slowing growth will be very difficult to explain to both the markets, and perhaps more importantly for them, to the politicians across the Eurozone. Ask yourself how the new antiestablishment government in Italy will respond given that nation’s desperate need for both NIRP and QE to continue.

In fact, the breadth of disappointing data today was impressive. From the Eurozone, we saw weaker than expected flash PMI data from Germany, France and the Eurozone as a whole, most of it the weakest since the beginning of 2017. We also saw French Unemployment tick higher to 9.2%, above expectations although not yet sufficient to describe as reversing a trend. From the UK we got both disappointing PMI data and lower than expected inflation data, with CPI falling to 2.4%, continuing its retreat from the November highs of 3.1%, and reducing the probability that the BOE will feel compelled to raise rates this year. Two things seem to be driving the inflation data, and both seem likely to continue. First is the fact that in the immediate wake of the Brexit vote nearly two years ago, the pound sold off sharply and remained there for quite a while. That led to higher import prices, which pushed up inflation. However, since then, the pound has rebounded quite smartly and as time has passed, that initial wave of price increases has passed out of the data. The second is that the overall growth rate in the UK economy is very clearly slowing down, thus undermining the idea that higher demand will drive prices up.

It can be no surprise that given the data releases, both the euro and the pound are sharply lower this morning (EUR -0.7%, GBP -0.9%) and plumbing depths not seen since December. In fact, both currencies are now lower YTD, and as I’m sure you must be aware by now, in my view have further to fall.

But today’s story is more than simply poor data from Europe; it really has the feel of an old-fashioned risk –off session. For example, the yen has rallied more than 1%, US Treasuries are up nearly half a point with the yield back down to 3.03%, and equity markets around the world are falling, with most down 1% or more. It seems that adding to the poor data story are some broader issues, things like a less sanguine attitude by markets regarding the trade situation between the US and China, the sudden sense that the meeting between President Trump and North Korea’s Kim Jong-Un may not occur after all, thus unwinding so much good will that the market had embraced, and the ongoing collapse of the Turkish Lira, which has fallen another 4% this morning and is working hard to catch up to Argentina for the title of worst-performing currency this year.

It is with all this in mind that we look forward to today’s session, where the FOMC will release the Minutes from its meeting back on May 1st and 2nd. If you recall, the big story then was the use of the word symmetric twice with regard to the inflation target of 2.0%. Pundits read that to mean there was a growing willingness by the FOMC to allow the inflation rate to run above target for a while before tightening too aggressively. Now, everyone is looking for a deeper explanation as to the rationale behind the change in language, and to see if we can get a clearer view of the future rate path. Remember, the market is currently pricing in rate hikes in both June and September, with a ~50% chance of one in December. Given that the data we have seen since the meeting has continued to show solid economic growth, I continue to look for that fourth rate hike, and for the markets to continue to favor the dollar as the year progresses. While I understand that long term questions about fiscal sustainability and its impact on the currency, which are decidedly negative in the dollar’s case, we are going through a period where cyclical relationships dominate the structural, and where long-established relationships, like the dollar following the path of US rates, have resumed their trends. This morning’s New Home Sales data (exp 677K) seems unlikely to change any views. Rather, the market is likely to remain in thrall to the ongoing deterioration of Europe and assorted emerging markets while it awaits those Minutes. In other words, look for the dollar to continue to perform well today.

The nation that’s shaped like a boot
Is causing some problems acute
Their fiscal adherence
Is lacking coherence
And frankly it does not compute

Once again the euro is under pressure this morning, although it has recently rebounded from its worst levels of the day, as the Italian political saga has taken another lurch forward. It appears that the anti-establishment coalition of Five Star and the League have agreed on a neutral party to be prime minister, Giuseppe Conte, a law professor from Florence University with no previous political experience. And while it is bad enough that the third largest economy in Europe is going to be led by a political neophyte, I think of much greater concern is the story about Italy issuing BOT’s as a means of financing the new government’s spending plans.

While there is not much information on this yet, these BOT’s are seen as potentially quite destabilizing to the euro with the possibility that they become a parallel currency in Italy. The last thing that the euro needs is another structural question. I assure you that Signor Draghi has not forgotten just how close the euro came to breaking up back in 2012 amid the Euro government bond crisis (remember “whatever it takes”?). Unfortunately for him, his home country has never been able to regain the ground it lost during that crisis and the economy there remains more than 5% smaller than it was prior to the crisis unfolding. Issuance of this new paper will be strongly opposed by virtually all the members of the Eurozone, but at this stage, it seems unlikely that the new Italian government will care. After all, their hallmark is that they are anti-establishment! While nothing has been agreed at this stage, and it may simply be another trial balloon similar to the story about the ECB writing off €250billion that circulated at the beginning of last week, the fact that it is even under consideration is testimony to just how difficult things are in Italy, and just how difficult it will be to bring that nation back into the Eurozone fiscal fold. While this process continues to unfold, I believe the euro will remain under significant pressure. Hedgers, keep that in mind.

While that was a new twist in the Italian story, the reality is that there has been very little else in the market narrative that is new. Trade talks between the US and China were inconclusive when they ended on Friday, but Secretary Mnuchin’s comment that ‘the trade war is on hold for now’ seems to have allayed fears within the equity investor community as stock markets around the world have rallied modestly.

Otherwise, there has been virtually no data of note released anywhere in the world. This morning’s pattern shows that the idiosyncratic stories from the EMG space, (Turkey, Argentina, Malaysia, Hong Kong, Brazil) have all continued along their previously determined paths. Perhaps the biggest news is that the IMF and Argentina have finally sat down to begin to negotiate the stand-by loan that the country desperately needs. But otherwise, today’s price action is simply an extension of what we have been seeing for the past several weeks.

Looking ahead to the rest of this week, data is sparse with Wednesday’s FOMC Minutes the clear highlight.

Wednesday

New Home Sales

677K

FOMC Minutes

Thursday

Initial Claims

220K

Existing Home Sales

5.60M

Friday

Durable Goods Orders

-1.3%

-ex transport

+0.6%

And that’s all on the data front. We do, however, hear from seven Fed speakers in a total of ten speeches with Friday’s comments from Chairman Powell likely to be the ones that everybody watches most closely. Of course, remember that Friday is the day before the Memorial Day holiday weekend here in the US, and so trading desks are likely to be lightly staffed then. That just means that if he were to say anything surprising (which I doubt) there would be the opportunity for more movement than usual given the likely reduced amount of liquidity that will be available.

All told, while things appear quiet for now, it is critical to remember that there are several important stories that continue in the background and that market liquidity is going to diminish as we hit the summer vacation season. That means that volatility is likely to resume its uptrend, especially if any one of these background stories comes to the fore. Nothing has occurred to change my view that the dollar has further to rally vs. all its counterparts, and until we see weak US data or a distinct change in tone from the Fed, things are likely to remain that way.

The League and Five Star have agreed
That looking ahead what they need
Is tax rates to fall
Plus income for all
And who knows, perhaps they’ll secede!

It’s official; the coalition between the two anti-establishment parties in Italy has been signed. While they haven’t yet named a PM, they are heading to President Matterella for official sanctioning and then will be presenting their government to parliament. The key platforms are the creation of a Universal Basic Income (UBI) for everyone below a certain level of earnings, and the imposition of a relatively flat tax structure, with just two rates, 15% and 20%. Given the way that fiscal policy is ‘scored’ by central banks and analysts, both of these proposals imply that Italy’s fiscal situation is going to deteriorate sharply. The combination of higher spending on the UBI with reduced income from the lower tax rates is a direct rebuke of Eurozone fiscal rules. And I understand that concern. But one thing that is important to remember is that Italians are notorious for not paying their taxes now, with much higher tax rates. They are almost Greek in their disdain for the process. Perhaps by cutting tax rates so dramatically, it will change some behaviors and, at least, maintain the current revenue stream, if not actually increase it. This would not be unprecedented. In Russia in 2010, tax revenues increased substantially after they changed the tax rates to a remarkably low 13% flat tax, as compliance improved significantly. The thing is the current scorecards don’t take into account human behavioral changes, and so it is entirely possible that the situation will not be as bad as some fear.

However, for now the situation has increased market uncertainty significantly. This is clearest in the Italian government bond market, where BTP’s have seen their spread to German bunds rise significantly in the past two weeks, from below 100bps to more than 150 today. It has also been felt in the Italian stock market, where the MIB Index has fallen 3% since Tuesday when the prospects for this outcome started to crystallize. And naturally, the euro has also been under pressure, with many pointing to Italy as one of the key reasons for the single currencies recent weakness. Of course, there are other reasons for the euro’s decline, notably the weakening growth and inflation data that we keep seeing, but Italy is not helping the cause. This morning, the euro is extending its losses, albeit slightly, as it remains anchored below 1.18 and is down a further 0.1%. I see no reason for this trend to end without a change in the data metrics. So if Eurozone data does not start to improve, look for a continued slide in the euro.

Poor Kuroda-san
Despite all he tries to do
Inflation’s absent

The other news of note overnight was the Japanese inflation data, where it once again disappointed, rising only 0.6% on a headline basis and 0.4% ex fresh food & energy. Not only was that below forecasts, but it also remains miles away from the 2.0% target. And there doesn’t seem to be any reason to expect that Japanese inflation is going to rise soon. Interestingly, with unemployment in Japan down to 2.5%, wages are rising more rapidly, with the latest reading showing a 3.1% gain. It seems to me that if I were PM Abe or BOJ Governor Kuroda I would be touting just how good things are for the country, with real wages rising sharply and prices remaining stable for those on a fixed income. But central bank orthodoxy won’t allow that type of thinking. Damn it, we need inflation to be at 2.0%!!!

The yen fell further after the news, now down 0.25% on the day, and trading back above 111.00 again. For now, it appears that this trend, too, will remain in tact. After all, it is abundantly clear that the BOJ is in no position to begin normalizing monetary policy given the inflation readings, while the Fed is not going to be deterred from its current path. I think we will continue to see Japanese investors looking at the dollar’s trend and the 300bp spread between 10-year Treasuries and JGB’s and decide that it is too good to miss, especially on an unhedged basis. Look for outbound Japanese flows to continue and the dollar to keep rising here as well.

In fact, the dollar is broadly higher this morning, although in most instances the movement has been modest. In the emerging markets we continue to see TRY crumble slowly (-3.7% this week), ARS crumble swiftly (-7.0% this week) and the other problem currencies (IDR, BRL, ZAR) all under pressure. Despite the fact that Brent crude pushed to $80/bbl, MXN is under pressure, as it appears the NAFTA story (No deal is imminent) is weighing on the peso. In fact, while each country has its own idiosyncrasies, right now the story is plainly based on the dollar. And until we start to see the data story change, with either US data missing or other nations showing better than expected outcomes, the dollar will continue to rule. A simple example was yesterday’s Philly Fed release jumping back up to 34.4, it’s highest reading in a year and putting paid to any idea that the US economy is slowing like the rest of the world. The sequence, for now, remains stronger US growth leading to higher US interest rates and a stronger US dollar.

There is no US data today although we will hear from two more Fed speakers, Brainerd and Kaplan. Thus far, we continue to hear that some FOMC members are thinking two more rate hikes this year while others see three. However, the big changes will come when it becomes clear that the ECB and BOJ, who have been touted to start reducing stimulus, have to admit that process will be delayed further. The week of June 11 should be quite interesting as on Wednesday, the Fed will have raised rates by 25bps, and on Thursday, both the ECB and BOJ meet. The divergence will be extraordinarily clear at that time, and we could well see the next leg higher in the dollar at that point. For today, however, given it is Friday and traders tend to square positions into the weekend, and given the dollar has performed quite well recently, I expect we could see a little profit taking and the dollar ease off a bit. But the long-term story remains clearly for a stronger dollar.

Perhaps today’s story is trade
Where NAFTA fans now are dismayed
Meanwhile ‘cross the pond
The EU has donned
The cloak of a partner betrayed

Some days, there is very little to discuss regarding the big picture, and even less to discuss regarding specific issues. Today appears to be one of those days, so I will be brief as I touch on the few things that seem to matter.

The Asia session revealed only two new data points of note, Australian jobs and Japanese outbound investment. The former showed an increase in full-time jobs of 32.7K that was larger than expected, and even though the Unemployment Rate rose to 5.6%, up 0.1%, the market looked at the jobs data and pushed the Aussie dollar up 0.5% at its peak, although it has since drifted back a smidge. However, it remains the best performing G10 currency vs. the dollar this morning. Meanwhile, Japanese investors increased the pace of foreign bond investment substantially, buying ¥827 billion last week as US yields are obviously becoming too attractive to ignore. The yen fell 0.25% on the news, trading back to its lowest levels since late January. One cannot be surprised at this given the BOJ’s ongoing efforts at yield curve control as they maintain 10-year JGB yields near 0.0%. When looking at that in comparison to US 10-year’s at 3.10%, the trade is pretty straightforward. This is especially true if investors are less concerned that the dollar is going to fall sharply, which of late seems to be the case.

Moving on to Europe, there was a distinct lack of data released and the only noteworthy comments came in the wake of an EU meeting in Sofia, Bulgaria, where the leadership coalesced around a position on trade. Essentially they said they were happy to negotiate a free trade deal, but would not do so with the threat of US steel and aluminum sanctions hanging over their head. In fact, they have a slate of retaliatory tariffs prepared to go in the event that the US tariffs go into effect next month. Interestingly, the euro, which had edged higher earlier in the session, fell after the news. Now it is possible that there was some other rationale for the euro’s decline, but I have not been able to find one. The single currency’s earlier strength had been predicated on the latest news from Italy, where yesterday’s story about seeking a write-off of €250 billion of debt has been walked back to where the Italians now want to be able to simply exclude debt held by the ECB from debt/GDP calculations. I guess that would help them move back toward previously agreed targets, but it certainly wouldn’t change the reality.

And finally, the news from the Western Hemisphere consisted of a surprise ‘no change’ by the Brazilian central bank, as they left the SELIC rate at 6.50% and appear to have abruptly come to the end of their easing cycle. Given the fact that the BRL has fallen 10% in the past month, their lack of a cut ought not be that surprising. And while Argentina continues to be a disaster, with no IMF agreement yet complete, more attention was paid to Mexico and Canada, where it appears that any completion of a new NAFTA deal will not be happening soon. Today marks the deadline discussed by House Speaker Ryan regarding the ability of the House to take up new legislation before the election season begins. And with the Mexican presidential election also looming in July, it seems like these talks will be on hold for a while. It is not clear to me if that means NAFTA will die, or if the status quo will remain until they resume. I am assuming the latter situation will prevail given the certain disruption a collapse of the agreement would bring to all three economies.

Taking all of this into account, markets are clearly undecided as to what to do next. Equity markets around the world are mixed with limited movement and the same is true with government bond markets and the dollar. In other words, traders are biding their time for the next potential catalyst. This morning’s US data brings only Initial Claims (exp 215K) and Philly Fed (21.0). Traders will be far more focused on the latter than the former as a strong number, like we saw from the Empire Manufacturing Survey, would likely serve as a reinforcement to the view that the Fed is not going to change its tack anytime soon. And given the Treasury market response to the Retail Sales and Empire data on Tuesday, a move that has not been retraced at all, I expect that a strong print could see another leg lower in Treasuries and another leg higher in the dollar. The narrative is slowly evolving from synchronous global growth to the US leading the way, and as data corroborates that view, the Treasury and dollar trends should extend further. I guess the real question is how long that can go on without equity markets coming under more renewed pressure. As to today, I expect the dollar to maintain its upward momentum barring an extremely weak Philly Fed print.

Apparently there’s some concern
Investors will soon start to spurn
New Treasury debt
Which could be a threat
To equity prices in turn

It seems that we could be heading back to the ‘good news is bad’ situation that existed several years ago. Yesterday’s Retail Sales data printed pretty much as expected at 0.3% although there were revisions higher to the previous data making the report, on the whole, seem quite robust. The immediate market reaction was a sharp sell-off in Treasury bonds with the 10-year yield touching as high as 3.09% before settling up 8bps at 3.077% at the end of the day. This is the highest level since March 2011 and has reignited the conversation about just how high yields will go. This morning’s punditry has seen an increase in the number of stories talking about a move to 3.25% or 3.50% before long and what might be the potential consequences of such a move. This cannot be that surprising as it has become increasingly clear that inflationary pressures in the US continue to point higher. Another tidbit is the fact that the Fed Funds futures market is now pricing in a 55% chance of a fourth Fed hike this year, its highest level to date.

The market impact beyond Treasuries was quite clear as the dollar surged to new highs for the move while equity prices suffered, albeit less than they might have. Interest rate spreads between the US and the rest of the G10 continue to widen in the US’ favor and as long as this continues you can expect to see the dollar supported. The historic link between rates and the dollar is firmly back in place at this stage, and I see no reason for it to break in the near future. As such, with US rates looking very much like they have further to rise, I’m confident the dollar will come along for the ride.

But that is not the only thing helping the dollar this morning, there are two other stories that have helped feed the evolving narrative of US growth leading the pack. First, Japanese GDP in Q1 shrank -0.2%, its first decline since Q4 2015, and a surprise to most forecasters. While the discussion is that this is a temporary phenomenon having to do with bad weather and uncertainty over the global trade situation, the reality is that while the US continues to see data at or better than expectations, the rest of the world is lagging. Interestingly, while the yen did fall during yesterday’s session, it has actually rebounded slightly, just 0.15%, this morning. The other story that is getting some press, although not as much as I expect it will eventually, is from Italy, where the League and Five-Star parties continue their negotiations to form an anti-establishment government, and have discussed the idea of writing off €250 billion of Italian government bonds!Given that Italy’s debt/GDP ratio is an unhealthy 132%, it can be no surprise that a completely new and reactionary government doesn’t want to be held back by their predecessors’ profligacy (after all, they have their own profligacy to consider!) However, if this actually moves into the Italian government platform, it is going to be devastating to government bond markets throughout the world, and I assure you that the euro will not fare well either. In fact, this morning the euro is down a further 0.4%, trading below 1.18 for the first time since December 2017. The trend here remains very clear and I continue to believe the euro has further to fall.

I have written before about the idea of a debt jubilee, where central banks tear up maturing bonds and leave the cash in the system thus reducing government debt outstanding and expanding the money supply. This would be highly inflationary. When looking around the world at record high debt levels, it is something that has to be considered possible. While I have always believed that Japan with its 230% debt/GDP ratio would be the first country to consider it, Italy had to be a candidate. And since it is evident that the new government is willing to consider radical changes in the way things are done there, I guess it shouldn’t be a big surprise. But it would have a monumental impact on financial markets if they were to do this, with risk being shunned everywhere and haven assets exploding higher. I’m not saying this is going to happen, just that the probability has clearly turned non-zero. Watch this space!

With all that in mind, the dollar continues to power ahead vs. both G10 and EMG currencies although most of the individual stories are less interesting. The one outlier this morning is ARS, which actually rallied nearly 4% yesterday after the government was able to roll over $26 billion equivalent of local currency debt, albeit paying between 38% and 40% to do so. While the market did take the news well, I don’t have to remind you that paying 40% interest is not really sustainable. If the IMF deal isn’t closed soon, I fear things there will really get out of hand. But that was the only bright spot on the day. We continue to see TRY (-1.8%), BRL (-0.9%), IDR (-0.5%) and KRW (-0.9%) lead the way lower across the board. And here, too, there is no reason to expect that the situation will change. In fact, the ongoing issue with the emerging market currencies is that higher US interest rates are beginning to compete effectively with investment opportunities in those countries. As such, investors are looking at 3.0% in the 10-year Treasury, a riskless yield, and it is starting to compare favorably to everything else available. Complicating the cycle for EMG economies is that they have been on a USD borrowing binge for the past eight years and it is becoming increasingly more expensive to service and repay that debt, weakening those economies. Here too, I think the dollar has further room to run.

Looking ahead to this morning’s data we see Housing Starts (exp 1.325M) and Building Permits (1.35M) along with IP (0.6%) and Capacity Utilization (78.4%). What we have learned from the inflation data is that the housing market remains robust. And given the tax changes, there is a clear expectation for gains in Capex, which should help the other data this morning. In other words, it is difficult to look at the data and come away with a rationale for either Treasuries or the dollar to reverse course. In fact, my take is that we could see the dollar continue to rally through the end of the week, whereupon traders are more likely to start taking profits before they go home for the weekend.

The synchronous global growth story took a few more body blows today as both Chinese Retail Sales (actual 9.4%, exp 10.0%) and Fixed Investment (actual 7.0%, exp 7.4%) disappointed markets. In fairness, IP rose a more than expected 7.0%, but the net outcome was a depiction of an economy that is being slowed by the government’s efforts to reduce leverage. And while that is no bad thing, it still results in slowing economic activity. In fact, the slowdown in investment points to a continued future slowing in economic activity in China. A little while later, Germany reported that Q1 GDP actually rose only 0.3% (1.3% annualized), half the rate of Q4 and lower than the 0.4% expected. This has variously been attributed to extreme cold weather in March, a flu epidemic and a series of IG Metal strikes during their wage negotiations. These explanations are an effort to highlight that this was a temporary phenomenon, rather than the beginning of a trend. And perhaps they are correct, although the April data thus far have not borne out that case. And it was not only Germany that came up short, but also both the Netherlands and Portugal failed to meet expectations. The point here is that thus far in Q2, the data have not indicated that Q1 was a temporary blip. Now it may well be that things have improved significantly and that will start to show up in the data soon, but to date, the evidence is scant.

It can be no surprise that the dollar has held its own in the wake of these releases, with the euro edging lower on the day while the renminbi has fallen 0.25%. Yesterday’s price action was a bit more volatile as the euro made a run at 1.20 in NY’s morning session (remember the Villeroy comments), but then declined steadily all afternoon essentially closing unchanged on the day. One of the themes I have seen lately is that the dollar’s recent strength can be entirely attributed to a short squeeze in positioning. I agree that the large outstanding short positions played a role, in fact I wrote about it several times in the past month. But despite the fact that there are long-term structural issues affecting the dollar, my read is that the short-term cyclical factors remain the dominant driver for now. With 10-year yields trading back above 3.0% this morning, and the data stream continuing to point to ongoing US growth vs. slowing growth elsewhere in the world, it is hard for me to make the case that the cyclical story is over. It is why I continue to look for the dollar to perform well in the near term.

Adding to the dollar’s overall luster is the fact that the problematic emerging market currencies are just getting more problematic. Both Turkey and Argentina have fallen to new historic lows this morning as their local situations deteriorate. In Turkey, President Erdogan has explained to the market that after the election next month, he expects to take more direct control over the economy, which implies that he will be cutting interest rates there. That is certainly not the traditional policy for a nation with rising inflation and a weakening currency, but in this case, I expect he is a man of his word. TRY has further to fall. In Argentina, there are essentially no bids for the peso, which fell another 7.5% yesterday as the central bank has stopped wasting reserves in an effort to slow the decline. Right now, the only hope is that the IMF stand-by loan of $30-$40 billion is agreed soon and investors are willing to believe that it will stabilize the situation. We’ll see. But it is not just those two currencies that are suffering. BRL fell more than 2 big figures yesterday, (0.6%) and is steadily marching toward 4.00 as the presidential election process there heats up. A mixed data picture in Brazil shows the consumer still hanging in there, but production data slipping. Certainly not the best of circumstances. And India has also been suffering lately, falling another 0.5% overnight after inflation data highlighted that the RBI likely needs to be a bit more aggressive in raising rates. And while the rupee has not yet traded to new historic lows, it is a scant 1% from those levels.

My point is that it feels premature to dismiss the dollar rally at this stage. This is especially so in view of the fact that there is zero evidence that the Fed is going to change its strategy of tightening policy via both interest rate increases and a reduced balance sheet. And so I won’t do so. Rather I remain confident that the ongoing data situation will point to the dollar continuing its rally for now. With that said, all eyes will be on Mario Draghi tomorrow morning when he speaks, as if he has turned hawkish at all, that would signal that the ECB is ready to actually change policy, something I don’t believe will occur, but something that would clearly underpin a less bearish case for the euro.

This morning brings arguably the most important US data of the week in Retail Sales (exp 0.3%, -ex autos 0.5%). We also see Empire Manufacturing (15.5) at the same time, but the sales data should dominate.

One other thing, the politics of trade policy has almost certainly had a market impact, even beyond the potential for it to drive inflation higher. The recent turn on the Chinese phone company ZTE, where the administration is now working to reduce the draconian sanctions imposed earlier has been taken by some as a sign that the trade negotiations with China may be moving forward. As there were many who expected the dollar to weaken in the event that the US became significantly more protectionist, this is likely a mild benefit as well. In fact, it is hard to point to something that is a clear dollar negative right now. Granted, weak US data would help to turn the tide, but it would need to be quite consistent in order to do so. In the end, based on the current evidence, I see no reason to alter my views. And for today, I think all signs point to a bit more dollar strength.